From the Portsmouth Herald, February 4, 2011
Money Talk: Caution: Inheritance ahead, handle with care
By David T. Mayes, EA, CRPC(R), CFP(R)
Most beneficiaries want to be sure these gifts of love are treated with care. Handling an inheritance, however, can present a complicated array of decisions and rules, ranging from how the funds will be taxed to how the money should be invested or spent to provide the greatest financial benefit.
Most financial experts agree making major financial decisions while you are grieving can lead to poor choices. Waiting six to 12 months before making investment or spending decisions is a good general approach. However, some items will need to be addressed sooner to avoid losing tax benefits. Generally, an inheritance comes in the form of bits and pieces of various accounts or assets. Rules for how you can receive these assets, and how they will affect your tax return, vary depending upon their type.
With trillions of dollars currently socked away in retirement accounts like IRAs and 401(k)s, tax-deferred assets are likely to be part of any inheritance. Mistakes in handling these accounts can mean sharing a large portion of an inheritance with the IRS, leaving less to help beneficiaries reach their own financial goals. Traditional IRA and 401(k) plan contributions are generally made with pre-tax dollars, leaving taxes to be paid by the beneficiary when funds are withdrawn. As a result, immediately cashing in these accounts can result in a large, unwarranted tax bill if the withdrawal pushes the beneficiary into a much higher tax bracket.
As long as the account owner named a beneficiary on their IRA or 401(k), the recipient can exert some control over when and how much tax is paid on withdrawals. Non-spouse beneficiaries cannot treat these accounts as their own. However, they can defer and minimize the tax hit on distributions by transferring the assets to a properly titled inherited IRA and taking minimum distributions over their lifetimes, with the first distributions starting in the year following the account owner's death. Beneficiaries can always take more than the minimum amount, if needed, but handling inherited tax deferred accounts in this way leaves them in control of the tax burden, not the IRS.
For non-retirement assets like brokerage accounts, simpler rules apply. The beneficiary can re-title the assets in her name and no tax is due until the assets are sold. Upon sale, capital gain income will be reported, but such gains may be minimal if the sale occurs soon after the loved one's death. This is because the beneficiary's cost basis for such assets is generally their market value on the original owner's date of death. Sales of inherited assets are always taxed at long-term capital gains rates.
Before you cash in your rich uncle's IRA or sell his stock, take time on your own financial planning by establishing short- and long-term financial goals to help you determine uses for your new-found resources. If you have not set up an emergency fund, putting aside six to nine months of expenses in a savings account or laddered CDs is a good place to start your planning. Paying off credit card debt should also be at the top of your short-term goal list. While it can be tempting to pay off a mortgage with an inheritance, this may require a bit more consideration, especially if the funds being used are coming from an inherited IRA. Over the long run, it may be more beneficial to continue paying your mortgage over time, leaving inherited assets to grow for retirement. Setting aside funds for a splurge is also OK, once you know your long-term goals are going to be met.
Finally, be sure to set up your own estate plan or have your current plans reviewed, particularly if your inheritance gave your net worth a substantial boost. This will ensure expenses, taxes and unnecessary delays will not diminish your loved one's legacy when passing to your children and grandchildren.
David T. Mayes is a certified financial planner professional and IRS enrolled agent at Mackensen & Co. Inc., a fee-only advisory firm in Hampton. He can be reached at 926-1775, david.mayes@mackensen.com or by visiting www.mackensen.com.